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Typically, advisors transact in exchange traded funds (ETFs) with the intent of those vehicles being deployed into client portfolios for extended periods of time. Longer holding periods can mitigate the need to closely examine spread and other total cost of ownership factors, but “longer” and “permanent” are different animals.
Translation: there will be times when advisors need to rapidly depart an ETF position(s) and they want to know that solid execution will be there to keep costs in check. After all, client outcomes are on the line and that amplifies the need to understand ETF liquidity and how it’s sourced.
Too often, market participants, including some advisors, make the mistake of judging an ETF’s liquidity on its on-screen volume alone when in reality, the ETF liquidity is derived from the assets held by the fund. That’s highly relevant because both equity and fixed income ETFs represent slivers of those overall market and, thus, a smaller percentage of average daily trading activity in those markets. The reason being is that the bulk of ETF trading occurs in the secondary market – a feature highly unique to ETFs and one that solidifies liquidity.
“In the fourth quarter of 2023, average daily trading volumes for the U.S. equity market (shares, ETFs, and depository receipts) and U.S. ETFs were $539.2 billion and $165.7 billion, respectively. This means that U.S. ETFs accounted for 30.7% of the total U.S. composite volume in the secondary market over the quarter, higher than the Q3 figure,” according to BlackRock.
Two Is Better Than One
“Secondary market” implies there are two markets – primary and secondary. The latter is crucial in identifying and supporting ETF liquidity, particularly when selling pressure intensifies.
“In the secondary market, where most investors trade, ETF liquidity is provided by ETFs trading on exchange. That’s enhanced by the primary market liquidity of the ETF’s underlying securities, which is sometimes even greater than an ETF’s secondary market liquidity,” notes State Street Global Advisors (SSGA).
How ETFs are created and redeemed is also essential in getting a handle on liquidity. That process occurs in the primary market between the ETF issuer and the authorized participant (“AP”). Those transactions occur away from traditional market settings and aren’t open to ordinary investors.
“APs create ETF shares in large increments — known as creation units — by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size, which is typically 50,000 ETF shares. The AP then delivers those securities to the ETF sponsor. In return, the ETF sponsor bundles the securities into the ETF wrapper and delivers the ETF shares to the AP. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange,” adds SSGA.
As demand increases, more ETF shares can be created, potentially providing more liquidity to the fund’s underlying assets and thus the ETF itself.
Tips for Preparing for Liquidity Events
No one has a crystal ball, meaning advisors don’t know when the next adverse liquidity event will arrive, but they can be prepared. Three steps to take include evaluating bid/ask spreads, trading volumes among an ETF’s held securities and valuations on high-octane stocks in a given ETF. The last point has merit because richly valued equities have penchants for being vulnerable to liquidity events.
“Each of these measures is impacted when volatility pushes investors to perceived safer areas of the market. With this flight to safety, bid/ask spreads may widen,” concludes SSGA. “Robust trading volumes may disappear. Stocks trading above their historical valuations may fall back to their multi-year average or lower. And the underlying liquidity for an asset class may be diminished. However, even with less liquidity, ETFs can function as valuable price discovery tools, providing insights into the market’s view on correct market pricing.”
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